December 16, 2021

Special Report: Tips From CIOs and Managers to Avoid Greenwashed Investments

Top CIOs suggest questions to ask when building your theses.

Reported by Christine Giordano

Whereas once there was whitewashing, or the practice of putting a shiny, fresh layer of paint over something not so sturdy—whether it be a rickety old ladder or a rotting piece of wood to give it a sparkling white varnish—now there is greenwashing, or painting over an investment that is not as green and solid when it comes to environmental, social, or governance (ESG) standards as the salesman would have you believe.

One such example of greenwashing is a real estate project painting a few parking spaces for electric vehicles, and the entire project being labeled green and pro-environmental. Similarly, another company added rows of bicycle racks to boost its environmentally friendly score. And while there’s no problem with bike racks per se, it may seem a bit misleading as a very high-scoring pro-environmental project.

Yet with a river of dollars flowing into ESG investments—a record $39 billion went toward sustainable funds in the US during 2021’s first two quarters, part of a record-breaking $1.9 trillion investment in sustainable funds globally—firms are clamoring to come up with projects to receive at least part of the flow.

On the risk side, some investors are keeping an eye on whether governments will mandate carbon pricing, which could rattle markets by putting a price on the external cost of greenhouse gas emissions and their environmental assaults (for example: crop damage, soaring health care costs from heat waves and droughts, or loss of property from flooding). Although they leveled off somewhat during the pandemic, emissions are on course to rebound to pre-pandemic levels, and, since 2000, CO2 emissions have increased 12%, and carbon in the atmosphere is higher than it’s been in the past 3.6 million years, according to the National Oceanic and Atmospheric Administration (NOAA).

And so, the US Securities and Exchange Commission (SEC) is trying to build a uniform way for companies to disclose their ESG methods, attempts, and successes. It’s not a simple business, however, even for investors planning their own portfolios.

Questions abound: Do you give a fossil fuel company high ratings if it purifies its processes, treats its employees well, has a strong and diverse staff, and has a strong governance structure? If a company offsets its emissions by planting trees or funding a new solar farm, is that enough? Is it OK to simply be carbon neutral if climate goals need to be more aggressive in order to avoid what some are predicting to be catastrophic environmental events if the world keeps heating? Or will most corporations need to aspire to be carbon negative? As an investor, should you care more about the world’s effect on the sustainability of the company than the company’s effect on the world? And while the disclosure framework process is still being built, board members and students are starting to clamor for immediate climate-friendly investments, which begs the question, as an investing allocator, what are some ways investors are effectively putting dollars toward ESG while avoiding greenwashing?

Defining Risk at CalPERS

The largest pension fund in the United States, the $495 billion California Public Employees’ Retirement System (CalPERS), studied its portfolio-wide exposure to climate risk (based on the Task Force on Climate-related Financial Disclosures [TCFD] report framework) and found that 20% of its global equity and investment-grade corporate fixed-income assets were invested in industries noted by the TCFD as being most exposed to climate risks.

“But in order to get to that point, we had to do a carbon footprint [analysis] of every asset class, which meant, for global equity, a carbon footprint [analysis] of 10,000 companies. We found less than 100 companies were responsible for 80% of emissions,” explained Anne Simpson, CalPERS’ managing investment director of board governance and sustainability.

CalPERS has about 18% of its private assets (i.e., real assets and private equity) invested in climate solutions, renewable energy, and sustainability-certified buildings, and it also has an energy optimization strategy that provides energy-efficient capital expenditure, or capex, investments into its real estate portfolio.

But becoming aware of the carbon risks within the portfolio was crucial to being a good fiduciary, Simpson said.

“I would say that the watch words ‘trust but verify’ should be ringing in the ears across leadership in the financial markets and the question of ‘verify’ is where we have fog. We don’t have a clear line of vision,” she said. There are sea-spiracies (with tuna labels proclaiming no harm to dolphins, a claim no one is verifying,) rainbow-washing (for diversity), and the “green gold rush” (where there is so much money to be spent on ESG that everyone wants to create a product).

“We don’t have the standards; we don’t have the integrated information,” Simpson said. “So we appreciate the complexity and how difficult it is, but there’s also the marketing opportunity with what you can call the ‘green gold rush.’”

In fact, some companies are offering tutelage in green compliance. If you want to build a green product, companies such as IQ-EQ help firms create their ESG policy. If a firm wants ESG alignment, those compliance companies will also help to chisel its image.

“The SEC has already come out and given us some risk alerts and let us know the things that are going to be a focus. So, on the compliance vertical, we actually created a mock ESG exam to help clients,” said IQ-EQ Director Libby Toudouze.

Just as there are many different ways to build a portfolio, and thousands of salesmen to get you there, there are now enough ESG products to color the industry green.

Bloomberg has charted how well companies are meeting their green goals, finding quite a few are falling short. COP26, the United Nations climate change conference held earlier this year, made strong headway, with more governments and companies promising environmental changes, but skeptics say the goals set there are not binding, are too far into the future, and aren’t aggressive enough.

But that doesn’t mean it’s time to green-smear the entire effort. It’s just time for investors to fine-tune their processes.

Building Objectives Internally

After surveying a number of allocators, the tip most give investors looking to enhance their green efforts is to start with your own objectives on the tenants of ESG investing. Are you seeking investments that are aligned with the goals of the Paris Agreement? Are you seeking to reduce carbon risk in your portfolio? Will you be investing in things that create carbon credits that are bought by those who need to offset their carbon output (i.e., new forestry that can be counted to offset carbon producers because it absorbs twice as much carbon as it emits)? Are you divesting from companies that harm children? Clarity will establish your guideposts.

The other advice from allocators is that investors get into trouble when they simply seek an ESG product without building out their theses. And, if you use consultants, not all may be equipped to handle your demands.

Start by telling your consultants what you want, whether it’s rigorously incorporating questions on ESG processes and due diligence, or reviewing all the funds in your portfolio. “And if they kind of blink at you like they don’t know what that means, then you need to have a serious conversation about whether they have the capacity to do that for you. And if they don’t, I don’t know, at this stage, with ESG so prominent, maybe it’s time to look around,” said Tim Brennan, who worked as an allocator for the Unitarian Universalist Association’s ESG goals. The alternative could be to hire a dedicated consultant for your ESG or sustainability goals, he added.

Whoever it is, that consultant shouldn’t be acting solo. The consultant’s work should be backed up, at least, by a research department at their firm.

“The best managers will implement ESG in a way that does not detract from returns,” said Carlos Rangel, CIO of the W.K. Kellogg Foundation.

“One of our lessons is that mainstream investors may achieve impact but view it as ‘value add’ instead of ESG,” he said. He noted an example where several real estate managers focused on improving workplace safety, HVAC [heating, ventilation, and air conditioning] efficiencies, or achieving LEED [Leadership in Energy and Environmental Design] certifications. Better workplace and climate outcomes result in higher terminal value for the assets. “These managers did not self-identify as ESG-focused managers in their most recent fundraise,” Rangel observed.

Since green bonds are also still in their early stages, and there can be bad actors in every investment pool, CIOs are watching to see if regulations get tighter for them, and whether there will be a third-party auditing system that gives them some type of seal of approval, similar to a LEED process in real estate.

“A solid standard would improve the market and increase the recognition of green bonds,” said Chris Ailman, CIO of the California State Teachers’ Retirement System (CalSTRS).

Fossil Fuels

Of course, there is more to sustainable investing than just switching from fossil fuel allocations to wind and solar investments.

Some funds, such as CalSTRS, are remaining active shareholders in their investments. CalSTRS, for example, joined the movement from the small hedge fund Engine No. 1 to push for sustainability-minded directors on the ExxonMobil board.

Ailman said he is also closely watching the job transition of those working in fossil fuel professions, noting that many of the workers don’t belong to unions.

“You can’t just eliminate these jobs. You’ve got to find a way to smooth the transition,” he said.

Along with job transitions, some are pondering how the $423 billion spent annually on fossil fuel subsidies could be reallocated toward the transition to developing cleaner energy technologies. Adding in money spent on stock options would make it even higher.

“Nearly $6 trillion worth of stock options and subsidies last year went toward the fossil fuel industry,” said Josh Brunert, senior associate at Apex Group. “And if you think about the fact that that’s taxpayer money going toward essentially causing part of the problem, if you start to shift even a portion of that money toward clean energy, then you’re going to really start to see a snowball effect.”

Of course, changes might not be easy, and some are resisting the transition to cleaner fuels. On the other side of things, after officials at the Department of Energy (DOE) dubbed natural gas “freedom gas,” in 2019, advertisements and public relations campaigns began proclaiming that there is a war against free will—e.g., that raising gas prices to keep people from driving is an assault on the freedom of Americans.

But North America and China are already considered laggards in the energy transition compared with Europe, which audits oil and gas companies and mandates that they disclose their long-term commodity assumptions because of the direct impacts they have on the valuation of assets.

Taxonomy

Data collection for managers that are eager to meet ESG disclosures has created even more business opportunities, as companies look to aid those who are preparing to disclose information.

“Most companies that we work with, 90% or so, have never done this before, so we’re really trying to educate them on how you, for example, monitor gender diversity, how you calculate your carbon footprint, things like that. Once we’ve collected that data, we can provide them with an understanding of where key gaps are versus their peers and versus regulators,” Brunert said.

Said Mark Fawcett, CIO of the UK’s National Employment Savings Trust (NEST), whose Climate Aware Fund excludes investments such as thermal coal. “I think the real challenge is on data and taxonomy.

“Getting the taxonomy right means we can get the data; trying to get the data better allows both managers and asset owners a way of really understanding how their portfolios are transitioning,” he continued. “At the same time, it reduces the risk of greenwashing. So I think that, for me, is the most important thing. We’ve adopted TCFD [recommendations].”

He said the other issue comes with carbon offsets, which polluters can buy as credits to offset what they’re pumping into the environment. Can they be sold more than once? Are they regulated?

“There’s a real issue about greenwashing, I think with offsets. There needs to be robust regulation,” said Fawcett, who has aggressive goals of halving the carbon exposure in his portfolio by 2030, and reaching net-zero carbon emissions by 2050. Emerging market sovereign debt will be a challenge, but sometimes the last percentages to net-zero emissions are reached through carbon offsets. Right now, renewables are his biggest overweight in his infrastructure portfolio. “In fact, currently the majority of our infrastructure equity portfolio is renewable energy,” he noted.

“The analysis we’ve done suggests that the increased focus on climate is helping these portfolios perform well,” he said.

Other CIOs, such as Barry Kenneth of the Pension Protection Fund, seek sustainability as a diversifier, investing in forests as carbon sinks, as well as sustainable cattle that are fed special diets that limit methane.

Accountability Advice

About four years ago, the Unitarian Universalist Association charged the consultant firm NEPC (led by Scott Perry and Kristine Pelletier) with helping to determine the extent to which its managers were meaningfully and systematically incorporating ESG factors into their processes. They assessed fixed income first, then equities, and then moved on to alternatives.

Part of the research involved asking such questions as:

If this is an alpha-seeking investment, where’s the data?
What have the results been?
Have you been able to separate out the effect of your ESG analysis from your other considerations?
Is ESG research integrated into your investment process?

Skeptics critique the lack of a singular, solid way of determining ESG metrics. Brennan, formerly with the Unitarian Universalist Association, argues that it’s similar to portfolio construction, and the thousands of managers who insist they have the latest and greatest way to construct a portfolio.

“Everybody has a different kind of approach. So it’s similar with ESG,” Brennan said.

Disclosures are still spotty. Some firms report information, others don’t. Yet if a company has completely decarbonized, greened, or purified its processes, but hasn’t disclosed enough information, would it get a lower score? Sometimes.

“If the disclosure is not there, there is, by definition, more risk, right? Because there’s more uncertainty,” Brennan explained.

Toudouze, from IQ-EQ, concurred. “If you’ve done all this work upfront but you don’t have the ability to monitor it or it’s too cumbersome and you can’t report on it, it kind of doesn’t work,” she said.

Impact funds must have quantifiable metrics. ESG funds tick the boxes that are material and relevant to what they’re invested in.

“And if you say you’re integrating it into your investment process, in your ESG policy statement, then you need to show how you are: Is there a cutoff? Are you using a ranking system? It’s really making sure it’s a consistent message,” Toudouze said.

And a company’s culture needs to be in alignment with the metrics that tell the story. For example, if a firm claims to have strong social impact messaging, with a diverse board of women and minorities, yet it has a 40% turnover rate (potentially indicating a toxic culture), it’s incongruent with its messaging, as well as its data, she said.

Pipedream or Plan?

The sweet spot will be to encourage a firm’s ability to innovate ESG solutions, long into the future, while having measurable progress markers along the way, experts say.

Oftentimes, the firm can envision part, but not all of the road ahead, because cost-effective assistive technologies have yet to be developed. Case in point: As an engaged shareholder, Brennan worked with the power company Xcel Energy for roughly five years on climate issues. During this time, the firm announced a pathway to 80% carbon emissions reduction and a goal to become carbon neutral by 2050.

Since then, it has developed a strategic plan for shutting down coal plants and presented information on barriers to implementation. It documented its progress. Yet at the time of its net-zero announcement, it could not see a clear path to decarbonize its last 20% of emissions. What the firm could envision, however, was that it would be prepared to make investments to help technologies be developed, and that incentives and policies would eventually be adopted that would be a tailwind.

“What management believed at the time, supported by the board, was that if you just looked at the progress that had been made recently over the last 10 years, even over the last five, we were now in places that almost couldn’t be imagined,” Brennan said.

Undercurrents Creating a Sea Change

There’s a rush of developments happening in the investment industry, with many allocators already creating tools and methods to assess the underlying indicators that relate to ESG investments.

When Michael Bloomberg and Mark Carney chaired and released the Task Force on Climate-related Financial Disclosures in 2017, it created a sea change, sending a clear message that climate risk was part of fiduciary duty. The guide was updated in a 2021 report to make it easier to implement climate-related risk and governance, strategy, risk management, and metrics and targets. It also created a framework for voluntary disclosure.

“What Mark Carney and Michael Bloomberg did as co-chairs of TCFD was indicate that climate wasn’t sort of a moral obligation that investors and corporates have in the back of their minds, but it was central and material to the financial performance of their businesses. So if, as an investor, you don’t consider climate financial disclosure and climate metrics, then you’re not adhering to your fiduciary responsibility because it has medium- to long-term risks on the underlying value of the asset,” said Hari Balasubramanian, founding managing director of the B corporation EcoAdvisors.

The UK, New Zealand, and some North American funds have already committed to TCFD disclosures. But experts say that what will catapult changes are government mandates.

Europe has created the Sustainable Finance Disclosure Regulation, or SFDR, a system of mandatory ESG disclosures that must be in place to facilitate allocator funding. It also applies to money managers in the United States who hope for allocations from Europe. The United States could follow once the SEC irons out more details.

Corporate directors are already discussing with boards how to incorporate sustainability into their core governance, with one of the main questions being: “What are the key indicators for ESG investing that make sense within a company that then can be reported to investors?”

Building Metrics

There are two different buckets of ESG indicators that are really important, EcoAdvisors’ Balasubramanian said: “There’s a bucket of metrics that relate to process and bucket of metrics that relate to outcomes.”

The outcomes are what the firm is trying to deliver from an ESG perspective. This is a tricky one. Because most companies and investors are still in the early stages regarding integration, five-year milestones and tollgates should be in place as guiderails. But if investors demand results and expect big changes too early in the game, it can be discouraging to those who are still planning their foundations for good governance and ESG investments. If this was a horse race, those investors would be essentially expecting a filly with no training to win the Triple Crown.

Firms trying to create a process should take note of the operational lines of their business and map out where they create material positive and negative impacts of ESG attributes. In essence, they should review where they are providing value or creating risk, Balasubramanian said.

“The ones that are doing it well are linking it to broader global systems like the United Nations framework under the Sustainable Development Goals [SDGs],” Balasubramanian said.

To fine-tune their approaches, under the 17 SDGs are 169 targets, and 232 unique indicators.

Once investors have mapped where their ESG practices create risk and value, it will be key to carve out which ones are going to be materially related to financial performance.

“And once you have that matrix, you can also compare against your peers. You can benchmark and baseline your performance and then understand where you save relative to the rest of your industry, or asset class, or sector, or segment,” Balasubramanian said.

Investors have to choose their goals and the indexes and measurements that align with them since ESG scores for companies can be vastly different.

“The leaders in the pack seem to those focusing on green infrastructure,” said Brunert, from Apex Group. “So this is particularly where there are high returns as well.”

In fact, one report from the Green Infrastructure Foundation notes a 6:1 return on investment, and shorter return on investment, when investing in climate-resilient infrastructure.

Ian Simm, of Impax Asset Management, wrote his reflections for investors after COP26, noting that clean power initiatives signed during the climate conference “should provide tailwinds for renewables, which already out-compete fossil fuel generation on cost in many markets, particularly in Europe.” Another area of opportunity will be energy efficiency “particularly to improve industrial processes, reduce losses during the transmission and distribution of electricity, and to improve the performance of buildings. More broadly, engineering solutions that advance resource efficiency and address fugitive carbon dioxide and methane emissions will also be in rising demand,” he wrote.

For tougher sectors, such as aviation, shipping, steel, and cement, “we see debt as the most likely way that companies will finance their ‘transition’ investments, which should create opportunities for astute fixed-income investors,” Simm said.

In the changing post-COP26 world, there will be many promising investment opportunities ahead, especially for investors who have their guideposts and theses in place.